Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Tuesday, May 18, 2010

Key Committee of European Parliament Approves Hedge Fund Legislation

A key committee of the European Parliament has approved draft legislation regulating hedge funds and private equity funds. The Economic and Monetary Affairs Committee approved the Alternative Investment Fund Managers Directive with improvements in transparency and risk reduction. The draft also embraces a proportionality system that regulates less risky funds more lightly, which means that private equity funds and investments trusts would be more lightly regulated than hedge funds and some types of alternative investment funds would be completely exempted from regulation.

Hedge fund managers in non-EU countries (third countries) would have to voluntarily comply with the Directive in order to have access to the EU. In such cases, the third country regulators of fund managers would act as agents to supervise the fund managers. Third country hedge funds could market their funds in the EU if their home country has high enough standards to combat money laundering and terrorist financing and grants reciprocal access to the marketing of EU funds on its territory and has agreements in place with the Member States on the exchange of information related to taxation and monitoring matters. The home country of the non-EU hedge fund must also recognize and enforce judgments given in the EU on issues connected to the Directive.

The committee-approved legislation contains a proportionality model for regulation of alternative investment funds under which different levels of regulation will be applied according to the type of fund rather than the asset thresholds proposed by the European Commission. National regulators will establish who qualifies for lighter regulation on the basis of the Directive’s rules. Private equity funds and non-systemically important alternative investment funds will avoid the full force of the Directive, while banks and pension funds investing only their own money will be completely exempted.

While the Commission proposed that it would set the maximum levels of borrowing that a hedge fund manager could use to increase the returns of a fund, the draft legislation approved by the committee would allow fund managers to set their own leverage limits for each fund they manage. National regulators would then monitor the suitability of these limits.While the Commission-proposed Directive prohibited hedge fund managers from doing their own valuations, the committee draft would allow this so long as safeguards are in place that provide for independent valuations. However, the delegation of valuation to an outside valuator will not shift liability from the fund manager to the outside valuator. If there is no external valuator, regulators can request that the internal fund system guaranteeing independent valuations be checked by an outside audit firm.

The main innovation on fund depositaries in the committee draft is that the depositary will be able to delegate its tasks to a certain extent, provided that it keeps a watchful eye on the actions of the sub-depositary it has delegated these tasks to. A depositary will also be able to delegate some of its tasks to a sub-depositary outside the EU provided it remains liable for the sub-depositary's actions, retains control over it, and the third country fulfils similar conditions required from non-EU countries wishing to have their funds marketed in the EU.

A depositary will be able to avoid liability for any loss of financial instruments if this is a result of force majeure or it can be proven that the cause of the loss was an unforeseeable external event. In the event of delegation, the main depositary remains liable for the actions of the sub-depositaries unless the depositary is legally prevented from exercising its role in the country where its fund manager is investing or could not due to unforeseeable external events. Finally, in the event of the sub-depositary being contractually able to reuse or transfer the assets, the depositary can then relieve itself of liability.

With regard to capital requirements, the draft proposes to align the Directive with the UCITS Directive. The Commission’s proposals on capital requirements for external hedge fund managers managing a fund are maintained. In the case of large value portfolios (over EUR 250 million) the text caps the extra capital needed at EUR 10 million. The Commission had not proposed any such cap. Moreover the committee draft provides that funds can be exempt from up to 50% of the extra capital required if they have guarantees by a bank or an insurance company matching the amount of which they are to be exempt.

According to the committee draft Directive, when a hedge fund has more than 10, 20, 30, and 50% of the voting rights of a non-listed company it must notify the relevant authorities and the investors in the fund in question. The manager must provide information on the communication policy with employees, plans for conflict-resolution and indicate which persons are responsible for deciding on business strategy and employment policy. Finally, hedge funds must give notice of any planned divestment of assets.

The draft Directive also deals with asset-stripping practices by requiring that the company owned by private equity must have capital which is in line with the requirements on capital adequacy established in already existing legislation on EU company law.

However, the private equity provisions will not apply to companies employing less than 50 persons. In this sense investment by private equity in micro-companies will be excluded from the Directive's scope. Moreover, the Directive calls on the Commission to review existing company law legislation to ensure that companies owned by private equity are not at a disadvantage in comparison to companies owned by other means, especially regarding reporting requirements and information which needs to be divulged to employees.

The committee draft enhances hedge fund disclosure. Most notably, new rules would require funds to inform investors about maximum levels of leverage (borrowing) and the total amount of leverage used by the fund, and to provide information on the domicile of underlying funds in case of fund of funds hedge funds and the domicile of any master fund. Managers would also be required to provide a description of the past performance of the fund, changes in liability if there is a contractual agreement between the fund manager and the depositary, and information about the role of sub-depositaries if these are being used.

Regulators would need to be informed about the overall leverage used for each fund, the ways fees are paid and the amounts paid to the fund manager, and performance data of the fund, including the valuation of assets. Regulators may also ask for additional information from fund managers which they consider may pose important risks. The European Securities and Markets Authority (ESMA) may also require additional reporting in exceptional circumstances or in order to protect the stability of the financial system.

The committee draft includes new features designed to reduce risk in the financial system, including new rules on remuneration, short-selling and marketing to retail investors. On remuneration, the draft requires fund managers to adopt sound policies and practices that do not encourage excessive risk. More specifically, it demands that remuneration policies be closely similar to those to be applied to banks.

The draft bans naked short-selling, a process of selling a security which is neither owned nor borrowed. It also requires fund managers regularly to disclose information on important short positions to regulators. It also provides that ESMA may decide to restrict short-selling activities in exceptional circumstances or to protect the financial system's stability.

On marketing to retail investors, Member States would have to ban the marketing of a hedge fund to retail investors on their territory if the fund invests more than 30% of its funds in other funds which are prohibited from being marketed within the EU.

The access by third-country hedge funds to the EU remains one of the most controversial issues in the proposed Alternative Investment Funds Management Directive. Recently, global hedge fund groups sent a letter to the European Parliament urging a reasonable and workable compromise on the third-party fund issue involving the access to non-EU funds and fund managers.

As the legislative process continues, a number of compromises are being considered. One such deal preserving the required choice of investment solutions for professional investors could be that Member States have the possibility of allowing private placement of non-EU hedge funds to professional investors within their own jurisdiction, and professional investors would be able to continue investing in non-EU hedge funds at their own initiative. Other voices have called for a reasonably conditioned equivalence coupled with a passport as the only long term solution able to conciliate internal market principles with free movement of capital and ensure a level playing field both within Member States and within EU based and third country based funds..